What is the cost of money, and how is it determined?

1
The Cost of Money

• What is the cost of money, and how is it
  determined?
• What factors affect interest rates?
• What is a yield curve?
• How do government actions and business activity
  affect interest rates?
• How does the level of interest rates affect the
  values of stocks and bonds?

2
Realized Returns
3
Cost of Money

• Interest rates are based on
• Production Opportunitiesgreater production
  opportunities, greater demand for funds
• Time Preference for Consumptionindividuals save
  less if they have a great need for current
  consumption
• Riskinvestors demand higher returns for riskier
  investments
• Inflationinvestors save to increase their
  ability to purchase in the future

4
Interest RatesLevels

• Function of supply and demand

S1
8.5
7.0
D2
D1

• Interest rates fluctuate continuously

5
Interest RatesDeterminants
Risk Premium RP
r rRF RP
rRF
Risk-Free Return rRF

6
Interest RatesDeterminants

• r rRF RP
• r IP

r rRF RP r IP DRP LP
MRP
r real risk-free rate IP inflation premium
r real risk-free rate IP inflation premium
rRF
DRP default risk premium LP liquidity
(marketability) premium MRP maturity risk
premium
DRP default risk premium LP liquidity
(marketability) premium MRP maturity risk
premium
RP
7
Premiums Added to r for Different Types of Debt

• Short-Term Treasury only IP for S-T inflation
• Long-Term Treasury IP for L-T inflation, MRP
• Short-Term corporate Short-Term IP, DRP, LP
• Long-Term corporate IP, DRP, MRP, LP

8
Term Structure of Interest RatesYield Curve
Upward sloping
Flat
Downward sloping
Short-Term Bonds Long-Term Bonds
9
U.S. Treasury Bond Interest Rates on Different
Dates
10
Term Structure of Interest Rates

• Explanations for the shape of a yield curve

• Expectations Theoryslope of yield curve is the
  same as expected interest movements
• Liquidity Preference Theoryinvestors prefer more
  liquidity to less
• Market Segmentation Theorymarket is segmented by
  maturity (LT or ST)

11
Interest Rates

• Other Factors that Influence Interest Rates
• Federal Reserve Policy
• Federal Deficits
• Foreign Trade Balance
• Business Activity

12
Interest Rates

• Interest Rate Levels and Stock Prices
• highly correlated
• Interest Rates and Business Decisions
• a firms decisions concerning what types of
  financing should be used for invest-ments in
  assets is based on forecasts of future interest
  rates

13
Forecasting Interest Rates

• Exp Infl
• Year Each Yr Avg Inflation Per Yr, IPt

20x1 1
20x1 1 1/1 1 20x2 5 (15)/2
3 20x3 6 (156)/3 4
20x1 1 1/1 1
20x1 1 1/1 1 20x2 5
20x1 1 1/1 1 20x2 5 (15)/2 3
20x1 1 1/1 1 20x2 5 (15)/2
3 20x3 6

14
Forecasting Interest Rates

• If the real risk-free rate, r, is 3 percent,
  then the forecasted yields on bonds will be
• Bond Type r IPt Nominal Rate, rRF

1-year bond 3 1 4 2-year
bond 3 3 6 3-year bond 3 4 7
15
Forecasting Interest Rates
20x1 3 1 4 20x2 3 5 8 20x3 3 6 9
1-year bond 4/1 4.0 2-year bond (4
8)/2 6.0 3-year bond (4 8 9)/3 7.0

1-year bond (4 8)/2 6.0 3-year bond (4
8 9)/3 7.0

16
The Cost of Money as a Determinant of Value
r required rate of return
17
Answers to Questions

• What is the cost of money, and how is it
  determined?
• The interest rate that lenders charge borrowers.
  Determined by the supply of funds and the demand
  for those funds.
• What factors affect interest rates?
• Production opportunities, time preferences for
  consumption, risk, inflation.

18
Answers to Questions

• What is a yield curve?
• A snapshot of the relationship between short-term
  and long-term interest rates at a particular
  time.
• How do government actions and business activity
  affect interest rates?
• Government borrowing exerts pressure on the
  demand for funds and may inflate interest rates.
• How does the level of interest rates affect the
  values of stocks and bonds?
• When rates increase in the financial markets, the
  values of assets decrease.